1. Field of the Invention
The present invention relates generally to trade clearing systems and more particularly to a system and method that enables traders to make positions held thereby fungible.
2. Description of the Background of the Invention
Exchanges enable buyers and sellers to trade financial instruments such as stocks, bonds, options, cash, agricultural products and commodities, and futures, etc. A futures contract is a financial instrument that represents an obligation for delivery or acceptance of another, underlying, financial instrument at a specified time in the future. The financial instrument that underlies a futures contract may include a quantity of grains, metals, oils, bonds, or cash. The exchange establishes a futures contract specification that defines the underlying product, a quantity of the underlying product represented by one futures contract, and an expiration date (when the delivery is to begin). The specification defines the expiration date for a futures contract in terms of a month and a year and the futures contract expires on a predetermined day of the defined month and year.
A futures contract may be traded in a physical exchange where buyers and sellers meet. A buyer and a seller use an open outcry auction process among other buyers and sellers to negotiate a price at which to buy and sell, respectively, a quantity of the futures contract. After the buyer and seller agree upon the quantity and the price, the buyer and the seller each report his/her portion of the trade to the exchange. The information reported by the buyer comprises identification information about the buyer, who the buyer believes is the seller, the quantity the buyer believes has been purchased, and the price to be paid thereby. Similarly, the seller reports information comprising identification information thereof, who the seller believes is the buyer, and the quantity the seller believes has been sold and the price to be received thereby. In some cases, the exchange encodes and transmits to a clearinghouse the information reported by the buyer and the seller separately as two sets of trade data. Alternately, the exchange creates and transmits to the clearinghouse matched trade data that comprises the information reported by both the buyer and the seller.
A futures contract may also be traded in an electronic exchange, wherein a trader submits an order to a trading host. The order is either a bid or an offer that indicates a desire to purchase or sell, respectively, the futures contract. The order identifies, at least, the futures contract, the quantity of the futures contract the trader wishes to buy or sell, the price at which the trader wishes to buy or sell the futures contract, and a direction of the order (i.e., whether the order is a bid or an offer). The trading host monitors orders that are received thereby to identify a bid (an offer) for a financial instrument at a particular price with an offer (a bid) for the same financial instrument at the same or lower (higher) price. Upon identification of the bid and the offer, a quantity associated therewith is matched and the quantity, price, and identification information regarding the buyer and seller are transmitted to the clearinghouse as matched trade data.
The exchange has separate markets that are designated to trade certain futures contracts. An open-outcry exchange typically has multiple trading pits with each trading pit, or even a portion thereof, designated for a particular market. Similarly, electronic exchanges have multiple markets where each market trades certain financial instruments and orders associated with each market are managed separately. For example, a futures exchange may have separate markets to trade futures contracts for delivery of 10-Year Treasure Notes in March, 2006, 2-Year Notes in June, 2008, Gold in February 2010, and Oats in March 2007, etc. Furthermore, futures contracts that have identical underlying products but that expire at different times are also traded in separate markets. For example, futures contracts for delivery of 10-Year Treasury Notes in March 2006, and for delivery of 10-Year Treasure Notes in June, 2006, are traded in two different markets
The trader who has sold a futures contract is said to have a “short” position and the trader who has purchased a futures contract is said to have a “long” position. A position held by a trader can be offset (eliminated) by obtaining an opposite position in a subsequent trade. For example, a trader who has a short position for a quantity of a futures contract may offset the short position by purchasing an equal quantity of the futures contract. Similarly, a trader who has a long position for a quantity of a futures contract may offset the long position by selling an equal quantity of the futures contract. In these cases, the trader who offsets the position for the quantity of the financial instrument eliminates any delivery or receipt obligation associated with the position.
Futures contracts can offset one another only if they are traded in the same market. Futures contracts that have different contract specifications (e.g., deliverable vs. cash settled, lot sizes, etc.) and thus are traded in different markets cannot offset one another in the manner described above.
The clearinghouse receives trade data regarding trades conducted during a trading session, matches trade data that is transmitted separately, and transmits matched (cleared) trade data to a clearing firm associated with each trader. Each clearing firm marks to market the account of each trader associated therewith. In addition, for each futures contract traded by traders associated with the clearing firm, the clearing firm calculates a sum of the open long positions and a sum of the open short positions in the futures contract held by traders associated with the clearing firm. The clearing firm thereafter reports the sum of the open positions for the futures contract to the clearinghouse. The clearinghouse records the open long and short position for the futures contract reported by each clearing firm. In addition, the clearinghouse calculates the open interest for the futures contract that is the sum of the open long or short positions held all reporting clearing firm. It should be apparent that the sum of the open long positions held by all reporting clearing firms is identical to the sum of the open short positions held by all reporting clearing firms. The clearinghouse reports the open interest for each futures contract to the exchange, which thereafter reports the open interest to traders and other interested parties.
The clearinghouse provides systems that a staff member of a clearing firm, can use to obtain open positions held by the clearing firm. For example, The Chicago Mercantile Exchange Clearing Services provides a system called Front End Clearing system (FEC) that the staff member of the clearing firm can use to obtain the status of trades made by the trader.
Most traders trade futures contracts with the expectation of liquidating their positions before the last trading day and thus eliminating any obligation of having to provide or accept delivery. Such traders expect to offset their positions by trading with other traders such that at expiry, the traders who hold the short and long positions in the contract are those who have sufficient quantity of the underlying product (e.g., Oats) to deliver and those who wish to receive the underlying product, respectively.
Futures contracts that are deliverable call for delivery of a specific grade of a commodity or instrument upon expiration, which is defined by the contract specification of the futures contract. For example, consider a futures contract for delivery of Oats in December, 2006, wherein each contract represents 5,000 bushels of Oats. A trader who holds 5 open short positions in this futures contract must deliver 25,000 bushels of Oats after the last trading day of December, 2006, unless the short positions are liquidated (i.e., offset) before then. Similarly, a trader who, after the last trading day of December, 2006, holds 5 long positions in the same futures contract, must accept 25,000 bushels of Oats if the 5 positions are not liquidated before then. Typically, the delivery or acceptance obligations associated with a futures contract must be fulfilled within a predetermined number business days after expiration of the futures contract and is specified by the specification of the futures contract defined by the exchange. To provide delivery, the trader who holds an open short position in a futures contract delivers warehouse receipts to the trader who holds an open long position for the quantity of underlying product represented by the short position. In some cases, the clearing firm associated with the trader who holds the open short position delivers the warehouse receipts to the clearing firm associated with the trader who holds the open long position.
The trader who holds the short position, but does not have sufficient quantity of the underlying product, must satisfy the deficit by buying a balance of the underlying product on the open cash market. Similarly, the trader who holds the long position but does not have a need for the quantity of the underlying product may sell the excess on the open market, possibly at a loss. In addition, the trader who is long and not in need of the delivery may incur additional expenses related to storage and delivery.
Other futures contracts may be cash settled. These contracts typically trade in an identical fashion to deliverable products and information regarding purchases and sales of such futures contracts are reported to the clearinghouse and clearing firms identically. At the end of each the trading session until expiry, the account of each trader who hold an open short position or an open long position in the cash settled futures contract is credited or debited, respectively, in accordance with the settlement price of the futures contract.
An exchange may have multiple future contract specifications associated with the same underlying product and expiration date. For example, an exchange may have full size futures contract and a mini futures contract, wherein the quantity of the underlying product associated with each mini futures contract is less than the quantity of the underlying product associated with each full size futures contract. For example, the Board of Trade of the City of Chicago defines specifications for a full size and a mini contract for silver, wherein both contracts expire in March, 2007. Each full size futures contract for silver is associated with a delivery of 5,000 ounces and each mini size contract for silver associated with 1,000 ounces of silver. The exchange may allow a trader who has accepted delivery of a full-size contract to convert a receipt for the delivery for an appropriate quantity of receipts for delivery of mini-sized contracts. For example, in the case of the Board of Trade of the City of Chicago a trader who has taken delivery of a receipt redeemable for a full-size (i.e., 5,000 ounce) lot of silver to exchange the receipt for five receipts for mini-sized (i.e., 1,000 ounce) lots of silver. Each of the five receipts for mini-sized lots of silver obtained by the trader in this manner may be used to deliver on a short position held thereby in mini-sized silver contracts.
At the expiry of a futures contract for a particular product, it is possible that a trader who holds a short position in a first futures contract also holds a long position in a second futures contract, wherein the two futures contracts are traded in different markets but the underlying product and the quantity of the underlying product represented by each position are identical. For example, the trader may hold 1 short position in December, 2006, Oats and 5 long positions in December, 2006, mini-Oats (each position represents 5,000 bushels of Oats) If the two futures contracts are cash settled, then at the expiry of the two futures contracts, the clearinghouse adjusts the accounts of the trader in accordance with the contracts. Some clearinghouses allow the trader who holds a long position in one cash settled contract and a short position in another cash-settled contract to request that the two positions be made fungible before expiration of either contract, even if the two futures contracts are traded in different markets. In response, the clearinghouse liquidates the positions held by the trader and credits the account of the trader accordingly.
If the clearinghouse is able to make two cash settled products fungible, and thus offset one another, then no deliveries of underlying products are involved. However, making a long position in a first futures contract and a short position in a second futures contract, where either the first or the second futures contract is deliverable fungible in this fashion would result in a situation, after settlement by the clearinghouse, where the sum of open short positions reported by clearing firms would not be identical to the sum of open long positions reported by the clearing firms in the specific markets where the first and second futures contracts are traded. At expiry, a trader would have an open position to either deliver or accept delivery of the underlying product involved, yet no one to receive or deliver the product, respectively.
In another situation, it is possible that the trader holds a position in a deliverable contract and an opposite position in a cash settled futures contract, wherein the quantity of the product underlying both contracts is identical. In this regard, the trader has no price risk for the positions held thereby in that the deliverable contract and the cash settled contract expire to the same settlement price. The cash settled product and deliverable products cannot be settled against one another despite their quantity equivalency because the two types of contracts trade in separate markets and thus are not fungible. In this example when the cash settled futures contract is liquidated on last trading day by means of cash settlement, the position in the deliverable future contract represents a delivery obligation to the trader as described above. Because of this delivery obligation and the risks associated with it, the trader desires to liquidate his position in the cash settled future contract and the deliverable futures contract prior to the last trading day.